This invention relates to a computer based method of and system for optimizing purchasing activity in a manner that maximizes expected returns while minimizing risk for the enterprise or multi-enterprise organization that is the buyer.
The spectacular splash caused by the Enron bankruptcy has made the public aware of something that professionals have known for a long time—the general ledger does not capture many of the factors that are relevant to accurately assessing corporate financial performance. In fact, the Enron bankruptcy was just the tip of the iceberg as a major financial news publication recently reported that “an examination of the 673 largest bankruptcies of public corporations since 1996 shows that in 54% of cases, no warnings were issued in the audit reports”. By now, the deficiencies in the general ledger system which include a failure to include intangible assets; a failure to include real option values; a failure to include data about most risks; and a failure to include data about the impact of most external factors are well known by most investors.
Unfortunately, the deficiencies in the general ledger have been replicated by all known systems for financial management, operations management, risk management and purchasing. These “narrow systems” are nominally supposed to help a business “manage” a subset of its operation. The specific deficiencies in narrow systems include:                1) failure to analyze the impact of change in the narrow part of the operation being analyzed/managed on related parts of the operation;        2) failure to consider soft (aka intangible) assets—this is closely related to the first deficiency because soft assets are generally more inter-related than many hard assets;        3) failure to analyze the impact of change on more than segment of value—most systems only focus on the current operation, the segments of value analyzed by the invention described herein are shown in the table below:        
Segment of enterprise valueValuation methodologyCurrent-operation Income valuationvalue (COPTOT) -value of operation that is developing, making, supplying and sellingproducts and/or servicesExcess net financial assets Total Net Financial Assets valued using(aka ExcessGAAP - (amount required to supportfinancial assets)current operation)Real Options & Contingent Real option algorithms and optionalLiabilities (aka Real options)allocation of industry optionsDerivatives - includes all Risk Neutral Valuationhedges, swaps, swaptions, options and warrantsMarket SentimentMarket Value* - (COPTOT + Σ RealOption Values + Σ Derivatives +Σ Excess Financial Assets)*The user also has the option of specifying the total value;                4) failure to analyze the impact of all relevant external factors on changes being suggested—many assume they can not be managed which is often not the case;        5) failure to analyze the impact of change on enterprise risk—most systems “handle risk” by adjusting the discount rate rather than analyzing the impact on all classes of enterprise risk as a result, actions that reduce enterprise risk can be ignored as they do not impact the valuation placed on the activity which reduces risk; and        6) a focus on “efficiency” rather than value impact; and        7) the use of outdated value metrics.Taken together these limitations severely restrict the usefulness of the analyses and management direction provided by these narrow systems.        
The seven limitations represent two general types of shortcomings in narrow systems. The first five shortcomings can be summarized in to a general statement that narrow systems do not have the contextual background they need for analyzing and managing the part of the enterprise they are designed to support. The implicit assumption in these systems is that the portion of the enterprise they are supporting is independent from the rest of the enterprise and the external environment. Because this is almost never true, narrow systems are generally operating in a manner that is out of touch with reality. Changing even the narrowest slice of the enterprise will generally have an impact on other tangible assets, other intangible assets, other segments of value and enterprise risk. Ignoring these impacts severely diminishes the value of the analysis and recommendations provided by narrow systems. Ignoring these impacts is the equivalent of a doctor providing a drug to optimize kidney performance without considering the impact on other organs and the overall health of the patient. The good news is the kidney is working great, the bad news is the patient died. Perhaps this is the underlying reason that some studies suggest American industry has wasted over $400 Billion on management systems that are not providing any payback.
At this point it is important to distinguish the strategic business context described above with the “administrative context” that is starting to appear in offerings from narrow system vendors. Some are using portals and similar applications to aggregate and display information from different systems to give the users a more complete background or context in which to make their decisions. The implicit message in these systems is “we think this other information might be relevant to your decision but we don't know how important it is so we will display it and let you figure it out”. A system that was able to sort through the different systems and consistently define the proper context for decision making would obviously be an enormous improvement. Other narrow system vendors are more focused on completing transactions in an automated fashion. Doing this requires among other things: the detailed procedure for completing the transaction (i.e. where the money goes, how soon it has to be paid, etc.), the details of the specific transaction—how much of which product should ship, etc. and recent transaction history. Unlike the strategic context information which has not been available from any system before the development of the methods and systems described in the cross-referenced patent applications, the administrative context information is readily available and the major reason for aggregating it in a server or layer is to speed processing rather than provide any new capabilities. Indeed, in the cross-referenced patent applications the readily available administrative context information is included with technical information, market information and the strategic business context information in the layers propagated by the systems described therein.
The second general type of shortcoming of narrow systems is a product of the final two limitations listed above. These limitations can be summarized as a reliance on metrics instead of direct measures of market requirements for value creation. The goal of all narrow applications is to improve market value for the firms that use them. Because of limitations in data availability, a historical shortage of processing power and the lack of robust models for the full spectrum of value creation in the modern enterprise, metrics such as accounting profit, EVA®, the Balanced Scorecard and CFROI® have been developed to give managers a shorthand method for evaluating the “value impact” of their decisions. Unfortunately, these metrics have an uncertain and highly variable relationship with actual market performance. For example, the value relevance of “accounting profit” has been declining steadily for 30 years. The declining relevance of accounting profits has a negative impact on other metrics which are generally some variant of accounting profit. Fortunately, the advances in data availability, processing power and the robust systems and methods for evaluating the full spectrum of value creation detailed in the cross-referenced patent applications enables the direct measurement of the requirements for market value creation. This eliminates the need for metrics which may or may not relate to market value creation.
The “efficient frontier” for each enterprise (as detailed in the cross-referenced patent application Ser. Nos. 09/994,720, 091994,739, 10,046,316 and 10/124,240) provides a concise way to overcome the seven specific shortcomings of existing narrow systems. A change that moves the company closer to its efficient frontier (when the frontier is defined using the methods and systems detailed in the cross-referenced application Ser. Nos. 09/994,720, 09/994,739, 10/046,316 and 10/124,240) would be one that on balance provided a benefit to the organization when all the relevant context and market requirements are properly considered in the analysis.
All known purchasing systems suffer from the limitations described above. In many cases these shortcomings are compounded by the fact that these systems also lack the ability to properly analyze the volume purchase discounts many suppliers offer. Because the great bulk of the cost of many manufactured items consists of purchased parts, the absence of a system that can effectively analyze the offerings from different vendors is a major problem for most companies. The severity of this problem has been exacerbated recently as firms seek ways to more effectively collaborate with their “partners” and suppliers rather than just simply complete spot transactions. One manifestation of this increased collaboration has been a willingness to share the risks as well as the rewards associated with new endeavors. Management systems that bury risk measures in the discount rate are obviously of little help when determining the best way to share risks.
In light of the preceding discussion, it is clear that it would be desirable to provide purchasing managers with the ability to optimize purchasing activity after considering the relevant context factors, market value factors and volume purchase discount schedules. Ideally, this system would be capable of optimizing purchasing activity for companies that are closely collaborating with their suppliers.